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AGU/POT | [Correction] Understanding the Terms

*The prior version of this note was sent in error

 

As we wrote previously http://app.hedgeye.com/feed_items/53543, we thought a logical expectation, given the relative multiples and investor interest, was a modest premium for AGU relative to POT. Judging by the market’s reaction to this morning’s news, the reappraisal of the combined entity as less Retail more Wholesale was not convincingly offset by the proposed synergies and other deal benefits.  Below we offer a few considerations that may be of interest as we learn more about the planned merger over the coming months:

  • End Markets and pending results in retail may be weaker given deal terms

Is it possible that Agrium was willing to do a not-so-accretive deal to change the narrative ahead of weaker results?  While a merger process may create a bit of a distraction, stress on North American Ag. is increasingly severe. Both companies are looking at potential margin pressure into 2017 just based on current crop prices and grower input costs.

  • We believe in some of the identified synergies but are curious to see what unfolds from an antitrust standpoint, since remedies could create offsetting dis-synergies

We expect the final terms to vary from the initial release to accommodate regulatory concerns, if the deal closes.  More likely, in our view, is that the merger is blocked per our earlier note "AGU + POT | Farm Misery & Antitrust Hurdles" http://app.hedgeye.com/feed_items/53463. Specifically, the combined entity’s pending control of North American distribution channels will likely raise red flags for regulators - AGU’s Retail segment complicates the merger review process. If regulators view distribution as a price + margin business, there would be limited incentive for Agrium to pressure the market with lower prices. Again, believe it or not, mergers in concentrated industries with existing cartel-like relationships can be problematic in antitrust reviews. 

  

  • By shifting away from its retail identity without a premium, AGU is taking on risk and disappointing some shareholders to get wholesale assets

The perceived stability of AGU’s retail margins on a go-forward basis have been treated very favorably by equity markets. The merger is a divergence from AGU’s North American retail-focused strategy without a straightforward offsetting benefit. AGU management is comparatively competent, in our view, and we will be interested to understand their agreement to deal terms likely to disappoint Retail-focused shareholders.

 

With the deal terms risk now past, we will add AGU back to Best Ideas.  We have several pending catalysts, including a potential merger rejection on antitrust grounds, an expectation for continued pressure on N.A. Retail margins, and likely input spending cuts an increasingly stress agricultural sector.


AGU/POT: UNDERSTANDING THE TERMS

Takeaway: The “merger of equals” gives way to some important considerations as the deal terms take shape.

As we wrote two weeks ago in AGU+POT | Farm Misery and Anti-Trust Hurdles , the logical expectation in our eyes was not a true merger of equals. Judging by the market’s reaction to this morning’s news, consensus was also thrown off by the headlines. Below we offer three important points to consider as we learn more about the planned merger over the coming months:

  • End Markets and pending results in retail are potentially weaker than expected

It’s possible that Agrium was willing to do a modestly dilutive deal to change the story, or at least distract investors with the hopes that more a more favorable environment is on the horizon. While the merger announcement may create a bit of a distraction to a worsening industry downturn, stress on North American Ag. is increasingly severe. Both companies are looking at margin pressure into 2017 just based on current crop prices and grower input costs.

  • We believe in the identified synergies but are curious to see what unfolds from an antitrust standpoint

We expect the final terms to vary from expectations to accommodate regulatory concerns. Alternatively, we see a low chance of consummation, and therefore are less concerned with favorable terms. Specifically, the combined entity’s pending control of North American distribution channels will likely raise some red flags for regulators - AGU’s retail segment complicates the merger review process. If regulators view distribution as a price + margin business, there would be limited incentive for Agrium to pressure the market with lower prices – If anything they may be incentivized and able to permit higher prices.

 

On the wholesale side, regulators may view Canpotex as evidence of previous collusion, viewing the added concentration as a sign that a combined entity would have a stranglehold on North American potash markets. 

  • A merger of equals suggests AGU was willing to pay up for wholesale assets, which is somewhat of a shift away from AGU's retail identity.

Based on financial performance the last several years, the perceived stability of AGU’s retail margins on a go-forward basis have been treated very favorably by the market. So the question we would ask is why didn’t the “crown jewel” contribute to deserving a premium in a merger with the much more concentrated and financially stressed business of POT unless there are some cracks in the outlook for the retail segment? The exchange ratio with Potash Corp. shareholder’s receiving 52% of the combined entity implied a per share value for Agrium under $90/share, where it was trading before the announcement. The merger is a divergence in the North American retail strategy that has been discussed in recent management commentary, and if nothing else we would ask if there was a shift in the perceived outlook and opportunity in persuing this strategy.

 

 


Looking For a Turnaround: Sector Sentiment Run

Takeaway: August Materials Sector Sentiment Run

Our monthly sentiment run is a behavioral, market-based gauge of investor sentiment in the Basic Materials Sector. Any relative performance measure is tied to an S&P 500 Materials Sector INDEX (GICS or XLB). Further screening methodologies are included in the link to the tracker below.

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Click Here to access the associated slides. 

 

Key Call-Outs:

 

Positive Sentiment (or more positive)

Negative Sentiment (or more negative)

 

  • Short-Interest: Gold Miners remain among the least shorted. Month-over-month, short-interest has shifted back toward the chemical companies (basic, diversified, fertilizer). 8 of 12 of the highest short interest names are in the chemicals space if Ag. Chem is included (Mosaic (MOS) and CF Industries (CF) are among the top 12).
  • Buy Ratings: After a shifting and re-shifting of miner short-positioning, metals & miners have consistently had the lowest buy ratings in the sector in 2016 (VALE, FCX, FMG). Mosaic (MOS) and Yara (YARIY) are also in the top 12. 
  • Combining consensus “buy” ratings and short-interest, Construction Materials (VMC, MLM) have the most positive relative sentiment when combining both metrics. Sentiment in the chemicals space is mixed. Looking at the sub-sectors in aggregate, sentiment among specialty and diversified chemicals is relatively positive when combining short-interest and "buy" ratings despite 8 of 12 with the highest short-interest being chemical companies.
  • Earnings Season: Sales and earnings growth has come in -8.8% and -6.7% respectively for the 21 out of 27 Materials names in the S&P 500 that have reported. The one sub-sector that has comped higher Y/Y for Q2 (sales +7.3% and earnings +41.3%) is construction materials (VMC, MLM).  Q2 will likely mark the 4th consecutive quarter for negative earnings growth for S&P 500 materials constituents.
  • LOOKING FOR A TURNAROUND: However, past Q2 2016, consensus currently expects a sharp turnaround in sector earnings (+6.1% in Q3, +19.1% in Q4, 20.9% in Q1 2017, and 12.0% in Q2 2017), so today's current forward multiple, near a cycle peak, has in it a sharp expected earnings turnaround on the whole.   

The Drought is in Credit: Key Call-Outs (AGU, CF, MOS, POT)

Takeaway: Fed farmer credit data shows 1) Tightening credit indices; 2) A decline in repayment rates; And, 3) A deterioration in land values.

The big question that will be answered in the intermediate-term is the effect of credit contraction, repayment rates, and land values on farmer input consumption trends. As we’ve highlighted with our recent calls in the Ag. space, we believe a deterioration in these metrics will prove meaningful:

  • The Chicago Farm Loan Repayment Index contracted from 43 at the end of Q4 to 32 through Q1 (-44% Y/Y) while the Chicago Fed Farm Loan Demand Index increased to 156 from 134 through Q4 (+11% Y/Y) – The Chicago Fed Fund Loan Availability Index was flat Y/Y.
  • The Kansas City Fed Loan Demand Index (nominal USD) is +6.2% Y/Y through Q1 and the Kansas City Fed Farm Income Index (nominal USD) is -73% Y/Y.
  • The Federal Reserve Bank of Chicago 7th District measurement of farmland values shows that farmland values are down -4% Y/Y, the largest rate of deceleration since Q3 of 2009. Cash rental rates for the 7th district are down -10% Y/Y.
  • Without having received updated data on past due real estate loans secured by farmland, loans 30-89 days past due were up 33% Y/Y through Q4, and there is no evidence to suggest a reversal in this trend.  

 

The Drought is in Credit: Key Call-Outs (AGU, CF, MOS, POT) - Chicago Fed Credit Indices

 

The Drought is in Credit: Key Call-Outs (AGU, CF, MOS, POT) - Chicago Fed Farmland Valuespng

 

The Drought is in Credit: Key Call-Outs (AGU, CF, MOS, POT) - KC Fed Credit Metrics

 

The Drought is in Credit: Key Call-Outs (AGU, CF, MOS, POT) - 30 89 Days Past Due Real Estate Loans Secured By Farmland

 

 


Earnings & Expectations - Key Call-Outs (Peak Forward Multiples)

The Materials sector, and the S&P 500 as a whole, is going on its third consecutive quarter of negative Y/Y earnings growth, and forward expectations have been taken down (obviously on a lag). With the sector now trading at peak forward multiples, below we ask the question, are forward-looking earnings expectations now too beaten-down, or is the current peak multiple a sign to be cautious of prospective returns? We would argue the latter.

 

*Note*: The S&P 500 GICS Materials Index only has 27 companies, so we’ll take a deeper look at expectations and different multiples for a larger sample next week in our monthly “Sector Sentiment Run” slide deck.

  • Earnings Growth: With Materials sector earnings down -18% this reporting season to date (after printing -18% in Q4 2015), Q1 2016 would mark the 3rd consecutive quarter of negative Y/Y earnings growth (see chart below).
  • Case for Peak Multiples: Without question earnings expectations have been revised materially for the obvious reasons, especially in resource-driven sectors. Every sub-sector beat bottom line expectations in Q4 despite the fact that earnings declined -18% (the same level we are currently tracking for Q1 2016). With the 2-month move in Materials stocks, does the market have it right? – The sector is trading at cycle peak forward multiples. 
  • Earnings & Expectations: Earnings growth beat estimates by 16.9% in Q4 2015 despite declining -17.9%. However, every sub-sector beat top-line estimates in Q4. This trend has continued for Q1 2016. So are earnings expectations too low, or is earnings manufacturing by corporations at unprecedented levels? Either way, the sector is trading at a peak multiple 7 years into a bull market, which in reality could be a much higher on a comparative basis, and we question the catalyst to take the market to much higher multiples without a correction. Again, we’ll look at this next week with a larger sample of companies.

 

Earnings & Expectations - Key Call-Outs (Peak Forward Multiples) - PE Chart

 

Earnings & Expectations - Key Call-Outs (Peak Forward Multiples) - Q1 COmps

 

Earnings & Expectations - Key Call-Outs (Peak Forward Multiples) - Q4 15 Comps

 

 


Jumping Beans - Key Call-Outs (SOYB, CORN, AGU)

Soybean market breadth has been strong on the CME – even unprecedented. Speculation behind the move has come from many different fundamental angles relieving U.S. farmers whether it be: 1) Brazilian farmers curbing forward-selling with political uncertainty; 2) Argentina unloading of record soybean stockpiles now being offset by unfavorable weather; 3) China shifting purchases from Argentina to the U.S.; 4) Macro - A weaker Dollar making U.S. crops more competitive in the global landscape.  

 

Whatever the correct story, the market has seen huge relative volumes and record levels of futures open interest behind the price move (some of it a structural change with ETFs holding futures contracts) off the end of February Lows with a huge long build in net futures and options positioning (table below), which we outlined in Monday’s call-outs. Implied vol. has spike triple digits (3-4x trailing averages in grains). See charts below for the behavioral set-up.

 

However, with regard to Y/Y farmer economics and FX moves (especially in the Real and Argentine Peso), we would need to see a sustained continuation in the short-term move before we would reconsider farmers’ beaten down propensity to consume crop input expenditures (fertilizer, seed, nutrients) in a time of credit contraction on the farm – farming realities move much slower than the CME, hence our thesis - the price of inputs has been slow to lag real-time grains prices out of the 2012 bubble highs, compressing farmer margins to dire straits. AGU’s retail exposure is more levered to the price of domestic corn, which like soybeans, is only up mid-single digits Y/Y against a U.S. dollar that is down -3.8% Y/Y. Continued unfavorable economics should weigh on the budgets of cash-strapped farmers who have gotten little relief in the price of seed, fertilizer, nutrients since the 2012 bubble highs in grains prices – YET – See last chart below.

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - Open interest

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - Avg. Volumes

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - price changes

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - Implied Vol

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - Contract Positioning

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - AGU Retail Exposure

 

Jumping Beans - Key Call-Outs (SOYB, CORN, AGU) - Seed Expenses 


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